World prices and business cycles in a small open input–output economy

Abstract

The role of terms-of-trade shocks in driving economic fluctuations is revisited through a multisector small open economy model, where the various types of goods can all be consumed and employed as inputs. Under this assumption, we show that, unlike conventional wisdom, terms-of-trade shocks may not necessarily trigger an economic boom for the exporting country if its export goods are intensively employed or consumed domestically, with limited scope for substitution. We calibrate and estimate the proposed model using data from 15 emerging countries and find that it performs better than the standard model to explain the different impacts of terms-of-trade shocks across countries documented by Schmitt-Groh and Uribe (2018). Such results make the model an excellent new framework to extend the analysis of monetary policies and the effects of price changes. • This study uses a multisector SOE model with a realistic input–output structure. • Common models overestimate terms-of-trade shocks’ impacts in emerging countries. • Using export goods dampens the expansionary effects of terms-of-trade shocks. • High elasticity of substitution between goods neutralizes the dampening effects. • The model extends the analysis of the price change effects.